Bank bonuses are bad

http://www.mercurynews.com/search/ci_14412031?IADID=Search-www.mercurynews.com-www.mercurynews.com (Follow the link to view the article by Bruce Wydick of USF or read the article below.)

What causes otherwise ordinary people to take extraordinary risks? A football team behind in the final seconds of a game throws a 60-yard “Hail Mary” pass into the end zone. A basketball team behind by a few points takes an inordinate number of three-point shots: The probability of a basket is lower, but the potential payoff is high. In both cases, the risky strategy creates the possibility of victory.

What does this have to do with the roots of our financial crisis? Plenty. Although the public outrage over bank bonuses has often seemed to flow from feelings of social injustice or a general animus toward Wall Street, the problem is far more consequential than this. Incentive bonuses given to bank executives create an environment that encourages a risk-taking behavior that undermines the stability of the entire financial system.

In order to align the incentives of corporate executives with the goals of a firm, top executives are often given performance bonuses. For publicly held firms, these bonuses routinely come in the form of call options, an option to buy stock at a certain strike price. The higher the executive can push the price of the firm’s stock, the more the options are worth, hence the motivational impetus.

But consider the incentives that are created when large financial corporations disproportionately compensate their executives with call options.

Under this type of compensation package, a steady, stable corporate strategy
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yields a low payoff to the bank executive, the mere base-pay of his salary. At least in the short-term, steady-as-you-go is unlikely to propel the company’s stock price upward to the point where the call option is “in the money,” where the stock price exceeds the strike price and the executive can cash it out at a profit. Indeed, the steady strategy is likely to compensate the executive little more than if the firm were to underperform and the stock price were to decline.

Notice the similarity with the sports team behind by a few points in the waning seconds of a game. Continuing to pursue strategies that ordinarily would be best for the team (a running play, a 10-foot jump shot) is no longer desirable because whether the steady strategy succeeds or fails, the team loses. Only the risky strategy yields the possibility of success, even if this probability is small. Moreover, the downside of the risky strategy yields an outcome that is no worse (losing the game) than any outcome that might result from the safe strategy.

For these reasons, bonus packages create an incentive to pursue volatile strategies such as the gamble executives in the financial world took on subprime mortgages. Based on the type of incentive contracts written for bank executives, rolling the dice on something as volatile as the subprime mortgage market was written in the cards.

Now, in general there is nothing wrong with aligning the incentives of an employee with the goals of a firm. And if firms selling garden hoses or lipstick or banjos want to induce their upper-management to take risks, that is their business. But banks are different. They are insured by the government, and society collectively bears the cost of their failure. When banks fail, the taxpayers pick up the tab.

This is why new reforms need to return banks to the relatively boring job of collecting savings from people and lending it to stable, creditworthy borrowers. These reforms must include rules that prohibit, or at least heavily regulate, executive bonuses.

This is not a populist cry for revenge against bankers. It is sound economics.

BRUCE WYDICK is professor of economics at the University of San Francisco. He wrote this article for the Mercury News.

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